Stablecoins and the Terra collapse

Wonder

1. What mechanism holds a token at $1.00 without holding dollars?
2. Why does a high yield on deposits accelerate instability rather than dampen it?
3. How can a collapse in one protocol trigger failures across unrelated lending platforms?

Explore

1. Stablecoins serve as the base currency for decentralized finance, bridging volatile assets and the real economy. Three primary models exist: fiat-backed, crypto-collateralized, and algorithmic. Fiat-backed tokens like USDT (launched by Tether) and USDC (Circle, September 2018) rely on centralized reserves of dollars or equivalents. Crypto-collateralized tokens like DAI (MakerDAO, December 2017) are backed by over-collateralized loans in volatile assets, subject to liquidation risks if collateral values drop.
2. Algorithmic stablecoins use economic feedback loops instead of direct backing. TerraUSD (UST), from Do Kwon’s Terraform Labs, maintained its peg through arbitrage: 1 UST could always be swapped for $1 worth of newly minted LUNA. If UST traded below $1, users bought it cheaply to redeem for LUNA at par, shrinking UST supply and theoretically pushing the price back up. This design removed the need for fiat reserves but introduced dependence on market confidence in the redemption mechanism.
3. The Anchor protocol incentivized holding by paying close to 20% annual yield on UST deposits, subsidized by Terraform Labs and affiliated reserves rather than earned from borrowers alone. This high yield attracted significant capital, creating a large user base dependent on the peg’s stability. The system functioned as long as redemption demand remained manageable relative to LUNA’s market capacity to absorb new supply without crashing its own price.
4. In May 2022, large-scale withdrawals broke the UST peg. As UST fell below $1, redemptions minted vast quantities of LUNA, which holders dumped on open markets. This flooded LUNA with sell pressure, collapsing its value. With LUNA worthless, the redemption mechanism lost its backing, causing UST to free-fall. The reflexive loop accelerated: a falling peg triggered more minting and dumping, erasing tens of billions in market value within days.
5. Contagion spread rapidly. Three Arrows Capital, a hedge fund heavily leveraged into Terra assets, collapsed. The lender Celsius froze withdrawals in June 2022 amid losses and a run, and Voyager failed after Three Arrows defaulted on a large loan. The failure demonstrated that algorithmic designs lack the external anchor of fiat reserves, making them vulnerable to reflexivity when market confidence evaporates.
6. Do Kwon was arrested in Montenegro in March 2023 and extradited to the United States in December 2024. In August 2025 he pleaded guilty in New York to fraud charges, and in December 2025 he was sentenced to 15 years in prison. The Terra collapse remains a defining case study in DeFi risk: code alone cannot guarantee stability without underlying asset backing or robust economic buffers against reflexive selling pressure.

Key facts

Exercise nine, six, three, one

Fact check

Dates, figures and claims checked against the published sources listed below.

• SEC v. Terraform Labs (2023-2024)
• US DOJ statements on Do Kwon (December 2024)
• Terraform Labs documentation (archived)
• MakerDAO white paper
• Circle, USDC Reserve Reports